In Part One we talked about the immutable law of taxation. By way of reminder:
As you increase the amount of tax deferred, you also increase the amount of control you have to give up to do it.
Since we have already discussed the “low-hanging fruit” of reducing gain and rate, let’s get to the meat of the discussion, and talk deferral.
Deferring gain is another great trick for two major reasons. The first is that tax rates are tiered. The more years we can stretch a gain over (generally) the lower the overall tax rate we will pay on it. If I can split my gain up over a couple years and stay out of the 39.6% bracket, I am going to be in better shape. We also are taking advantage of the time value of money. I will gladly pay you Tuesday for a Hamburger today. But how?
Stretching Out the Taxable Income
The most common way to stretch out a gain is through a method called an installment sale. If you sell something for $500k, and have $300k of gain, under normal situations you would receive $500k and pay tax on $300k. But if you sell it and you agree to take your payment in five equal installments of $100k each for five years (usually plus interest), then the gain of $300k will be recognized at $50k a year for the five years. $300k is enough to jump several tax brackets. $50k might not be. You also get five more years of deductions to take against the gain. Sounds awesome, right? And it is! Except that you run the risk of the buyer going bust and never paying you. See what I mean about limitations? If you want all the money now, you pay all the tax now. If you are willing to reduce your level of control (because all you have is a promissory note, not cash) you can save a bunch of tax! No right or wrong here, just a different situation.
What if you don’t need the money right now, want to do an installment sale, but don’t trust the buyer to pay you? That is where the other option, a Deferred Sales Trust, comes in. Basically it works the same as an installment sale, but instead of getting a promissory note from the buyer, you sell the assets/stock to a trust for the note (which has to be run by a neutral third party) who then sells them to the buyer. The trust basically holds the cash and pays out on its promissory note to you. That way you still can stretch it out, but you have more security because the note is backed by assets you can verify. A couple caveats on this though. First, for this to be an arm’s length transaction, the trust has to have a profit motive. Which means that if you charge 5% interest on the note the trustee is going to invest that cash and try to make more than 5%, generating a profit for itself. Which means it could lose the money. Secondly, this setup has only been approved by the IRS via Private Letter Ruling. What does that mean? It’s complicated, but basically the IRS could come right back and say “never mind, we don’t like this and don’t want you to do it anymore” and force you to pay the tax, plus penalty and interest at any time. It is legal now, but the IRS can make things retroactively illegal. That’s right. I have seen it happen. They basically say, “Well yeah, it was legal when you did it, but now it’s not so you broke the law when you did it. Sorry.” Again, risk and reward people!
Another great option, usually only available to attorneys and other people that do contingency work is a structured settlement. Basically if you work for a portion of a reward (like a lawyer suing someone on your behalf), instead of having them pay you 30% of the settlement directly (the typical fee) you can write into the settlement that they have to pay you a monthly payment for life (or for 20 years, or five years, or pay you in three years, whatever you want, really) instead. This is accomplished by their taking the 30% and buying an annuity to fund their obligation. This is very similar to an installment sale as you only recognize the income when you receive it. This is a pretty niche trick though, so I won’t spend much time on the ins and outs.
The other option for deferring is what I call the reverse deferral. In this situation you do not defer the gain, you pay it all at once. But you defer the opportunity to take losses and deductions against it. Primarily you use the Net Operating Loss (NOL) rules to accomplish this. The NOL rules allow you to “carry back” losses in the current year up to two years. So, let’s imagine that you do an asset sale of your business in 2013 and get $1MM. You still own the corporation. We set up a defined benefit pension plan and defer $250k into the plan for 2013, which means you have income of $1MM minus expenses of $250k for taxable income of $750k. Ouch. But you pay your tax. In 2014, you defer another $250k into the pension plan. You have income of $0 minus expenses of $250k for a $250k loss. You carry that loss back to 2013 and file an amended return. You take the $750k profit minus the $250k loss and get a refund. Repeat this process for 2015. In the end, you moved $750k of the $1MM into a pension plan (which you can withdraw from at whatever rate you want, whenever you want, thereby stretching the tax out) and paid tax on only $250k now. This could work for all kinds of other expenses, by the way, not just a pension plan. If your company still operates it might still need to have a company car, a company phone, or might have meals and entertainment expenses. All these deductions add up to what you can carry back.
Another method of the reverse deferral is to use something like a Family Limited Partnership (FLP). With this setup you make a partnership and contribute the assets you plan to sell. Typically to stand up, this needs to be done years before the sale takes place. You gift shares of the partnership to family members (primarily kids). When the asset sells, that gain is split up amongst all their returns, thereby stretching the gain across lots of smaller tax brackets. This tool is primarily an estate tax tool and not an income tax tool, but it can be used to help offset income tax while you are accomplishing your estate tax goals. As a side note, like in the NOL example above, the FLP might have operating expenses that it can pay that would be used to offset future or past gains. This tool can work really well if you want to give money to your kids now. And you have to. You cannot run an FLP and then not distribute the assets to them. Remember what I said about having your cake and eating it, too? You can’t use your kid’s tax brackets without losing that money.
Gone for Good
The only trick that comes close to having cake and eating it is the stepped-up basis on inherited property. This is a pretty good trick. Let’s go over some terms. Remember, you pay tax on gain. Your gain is your sales price (X) – minus your basis (Y). Your basis is, typically, what you paid for it. It can be increased if you put more money in and decreased if you take money out. But to keep the example simple, assume it is what you paid for it. So X – Y = your taxable gain (Z). Z is what you pay tax on.
Now let’s assume Mom and Dad bought a house. They bought it 30 years ago and lived in it their entire lives. They paid $50k for the thing and now, when they both pass away, it is worth $750k. If you live in Southern CA like I do, this is a pretty common story. If Mom and Dad sold the house, they would pay tax on $700k ($750k – $50k). With me? Ok, now assume instead of selling the house, Mom and Dad pass away and leave you the house. What is your basis in the house? It gets “stepped up” to the Fair Market Value on the date of Death. So, your basis is now $750k. You immediately sell the house. You sell it for $750k with $750k of basis. How much tax do you pay? That’s right! ZERO! Death is the only legal way to make income/gain disappear forever. This works for any inherited assets: real estate, closely held businesses, stocks, bonds, etc.
Of course, in keeping with our theme of everything having a downside, with this, the greatest way to eliminate tax ever, you have to die. So there’s that. But still, neat trick right?! When you combine this with the 1031 exchange rules for real estate it can be a really great combo. A 1031 exchange allows you to not pay tax on the gain of a sale of real estate, as long as you immediately reinvest the proceeds from the sale in another property. So, if you have decided that you will always have rental real estate as part of your portfolio you can not pay tax on any gains, keep rolling the money over into new properties as the market allows. Then, all the gain you make along the way will be 100% tax free because whoever inherits the property will get a stepped up basis. Of course the other downside is that all that gain becomes taxable if you ever need the cash out of the property.
That is all the basics you need to know about deferral. Hopefully you can find something useful to help you! In our third and final part of the series, we are going to discuss ways to completely eliminate taxes.
If these strategies are interesting, or you think you might need additional help, please go to the contact page. I would love to work with you!
Big shout out to Jason Rehmus and http://sweatingcommas.com/ for all his help in making this readable. I would be unintelligible if he wasn’t around.